What a ride! In our search to explain marekt trends over the past several months, and now with the failure of some of the most well-known firms on Wall Street, we point you toward this article taken from Bill Gary's Price Perceptions titled, "Commodity Disinvestment" 

    Over the past year, there has been a great deal of controversy over specualtion in commodity markets. Grain elevators complained futures were trading well above what the grain could be sold for in cash markets... Cotton merchandisers said they lost millions in hedging operations as futures advanced much faster than inventory values... And, Congress attacked the Commodity Futures Trading Commission (CFTC) for allowing speculators to run up energy prices and push the economy toward recession.

    The speculative binge in commodities began when Congress passed the Commodity Futures Modernization Act of 2000. The new law provided the mechanism for stocks to be traded on major exchanges based on commodity values. This opened the door for the Exchange Traded Funds (ETF's) in commodities. It also deregulated certain kinds of trading in futures called "swaps" with no government oversight. This portion of the new law later became known as the "Enron Loophole".

    Since passage of the law, many new stocks were introduced on major exchanges that track individual commodities such as wheat, gold and crude oil. Pension funds and endowments, previously barred from trading commodity futures, could now invest in stocks that track prices of individual commodities. Major Wall Street firms joined the bandwagon by introducing 'index funds" that track major commodity indices such as Goldman Sachs Commodity Index. They also introduced commodity "swaps" that facilitated large off-exchange trades. Swaps allowed industrial clients to lock in a commodity price for months or years ahead. For instance, an airline could buy a swap guaranteeing millions of gallons of jet fuel to be delivered in New York one year ahead while an oil company could take part, or all, of the opposite side. If a seller could not be found for the opposite side, the Wall Street firm could hedge the other side through complicated formulas utilizing crude oil or heating oil futures. Securitization made commodities an "asset class" and became a boon for Wall Street banks.

    Securitization of commodities attracted billions of dollars from pension funds, endowments, hedge funds and others who had not been previously involved in the volatile commodity business. The flood of index money into commodity markets is estimated to have grown from $13 billion in 2003 to $223 billion this year. This staggering increase of %1600 in primarily "long only" index funds is believed to have contributed strongly to record high commodity prices earlier this year. Some compare the huge influx of money in the commodity markets (index funds $223 billion alone) with this year's entire US wheat crop, worth only $17.4 billion. 

    Congress called for the CFTC to investigate the huge influx of money moving into commodity markets and whether or not it pushed energy and other markets higher than justified. Since that time, the CFTC has concentrated on the makeup of buyers and sellers in the crude oil market. In some cases, they found oil firms bought more contracts than justified under the pretext of hedging. In some casses they found funds trading above the prescribed limits. In others, the CFTC changed their classification from hedger with no contract limits to speculator with limits. The investigation resultted in net liquidation of open contracts in crude oil and a decline in price from $147 per barrel in July to today's break through $100.

Some fund managers, testifying before Congress, indicated excessive speculation was a primary cause of the recent oil price spiral. Also, a detailed study by the Massachusetts Insititue of Technology (MIT), released in June, blamed excessive speculation for the historic rise in crude oil prices. This week, the CFTC released their findings to Congress. They reported index investors held $118 billion in US commodity markets on December 31, 2007 and had incresed investments to $161 billion by June 30. However, they did not go as far to blame this year's historic commodity price advance on index funds and swaps. But, they said consideration should be given to eliminating the hedge exemption for swap dealers.

    Many hedge and index investors have withdrawn from commodity markets, as uncertainty grows over potential CFTC investigations and possible restrictive legislation from Congress. The outflow of funds from these investment vehicles has pressured all commodity markets over the past two months. Without support from new speculative money, commodity markets are likely to retrace many of the gains of recent years.

Dave Bauer

Brite Futures Inc.

 Those who cannot remember the past are condemned to repeat it.

George Santayana